Everyone knows bigger is better. Bigger houses and bigger cars
are signs of bigger paychecks and bigger success. The stock market
has echoed this theme, with the large companies housed in the Dow
Jones Industrial Average and Standard & Poor's 500 (S&P
500) racking up, well, really big gains for the past two years.
Actor Tom Hanks could tell you that "Big" was good for
him. But as comedian Steve Martin once put it, maybe now's the
time for everyone to get small . . . small-company stocks, that
is.

At first glance, the question seems academic. Why should
investors abandon what seems to be a sure thing to embark on what
could be a volatile and risky relationship? After all, for the 12
months ending April 1997, the total return of the Russell 2000, an
index of small stocks--also known as small caps--lagged behind the
S&P 500 by a big 20 percent--the second-worst
trailing-two-month performance in the history of the index. But
Claudia Mott, director of small-company research at New York
City-based Prudential Securities Inc., a full-service brokerage
firm, notes that now could be the time to take the plunge.
"Historically, the average return for the Russell 2000 in the
six-month period following substantial trailing-12-month
underperformance is well above 20 percent," says Mott.
"Although many of these periods overlap, there have been only
three subsequent six-month periods in which the small caps
underperformed the S&P Composite." Yet the question
remains: Should small stocks be a part of your portfolio?

Share the wealth

Why small companies now? In addition to their relatively poor
recent past performance, several trends make this sector
attractive. Many investors, tired of watching their small-company
stock values decline while large-company shares hit new highs, have
redeemed shares in small cap mutual funds to switch to the big
guys. This selling pressure has forced fund managers to liquidate
shares, dropping stock prices still further. Outflows seem to have
ceased, however, replaced by new money being invested in a sector
that seems undervalued. This inflow of funds has somewhat
stabilized the price of some of the top small cap stocks and led to
an increase in mutual fund share prices.

The recently passed capital gains tax cut should also benefit
small caps. While stocks tend to be sold off in response to a cut
in the capital gains tax rate, the reaction is often short-lived.
Small cap stocks have tended to do well when rates fall, as
evidenced in the late '70s and early '80s, when their
performance outshone that of their larger cousins. On the other
hand, when rates have risen, small stocks have underperformed large
ones. Strong economic earnings have been positive for small caps,
recessions negative. Most economic soothsayers see smooth sailing
ahead, a good sign for small companies.

Finally, comparisons between the prices of large- and
small-company stocks show the latter to be a bargain at today's
prices. Currently, small cap stocks appear to be one of the last
relatively cheap alternatives in a market that has soared beyond
most investors' wildest expectations. The case for small
companies strengthens.

Baby steps

On the surface, the case for small caps looks good. After all,
history tells us that over time, small caps outperform large caps,
right? Although past performance is not an indication of future
returns, a study done by Ibbotson Associates, a financial
consulting and software firm in Chicago, shows that hypothetical
long-term investors in small-company stocks had a lot to be happy
about. Assuming reinvestment of all dividends and capital gains,
one dollar invested in 1925 in small cap stocks would have been
worth $4,495.99 at the end of 1996. The same dollar invested in
large cap stocks would have grown only to $1,370.95.

Even if small caps do outperform large caps over time, the ride
is anything but smooth. With the possibility of higher returns
comes higher risk; while some small companies may rocket into outer
space, others have been known to come back to earth with a
sickening thud. "Yet anyone who's not about to retire
should have some small cap exposure," says Mott. "If
you're going to buy a [small cap] fund, you should hold on to
it. People have lost some of their investment by trying to get in
and get out [too quickly]." The idea is to get in and hold on
for the long term.

If you're concerned about taking too much of a risk,
consider investing in small caps slowly--invest a set amount
monthly in a fund, and do it for the long term. Before you invest,
be sure to read the fund's prospectus and review the asset
allocation of your current portfolio. Then consider devoting a
small portion to small caps. Be prepared for a wild ride; the
prices of small caps generally are more volatile than those of
large-company stocks.

A little here, a little there

If you prefer to put together your own portfolio of
small-company stocks, do so cautiously. Unlike the Dow's
components, analysts who follow the smaller stocks are few and far
between. Information can be scant, too, making it hard to decide
not only what to buy but when to sell. Finally, many smaller issues
are quite illiquid, making it difficult when it comes to selling
shares.

Experts advise sticking with industries you know. If you own a
small company that markets computer software, start in the
technology industry. Keep abreast of industry trends through trade
magazines, and be sure to get a copy of the company's annual
and quarterly reports before you decide to invest. Look for
companies with good management, little or no debt, high ownership
of shares by insiders and a unique niche in an industry. Savvy
investors also avoid those companies that have high ownership by
institutional investors, like mutual funds. Wouldn't you want
to go where the pros go? Definitely, but it helps to beat them to
the punch. If the shares of a company you like are thinly traded
and few in number, a mutual fund's purchase could cause share
prices to rise--enough for you to get out at a higher price.

As an investor in this volatile and risky sector, once
you've picked a company, keep your exposure to it small. Unlike
large, multinational firms that boast many products and services,
the fortunes of a small company may ride on just one product.
Problems with production or packaging could put it out of
business.

Whatever you decide, don't fall in love with a small-company
stock. You may have put tremendous time and energy into selecting
and following it, but be alert and responsive when its fortunes
change so you can either collect your profits or cut your
losses.

Make sure your portfolio is diversified. If you don't have
the money to buy stock in several companies, consider a mutual
fund.

Small chance

Whether you choose to go the mutual fund route or decide to pick
your own small cap stocks, consider the style of investing and the
type of companies you're picking. In general, there are two
styles: growth and value. Growth companies are those with the
highest earnings-to-growth rate. They tend to do well in poor
economic times. Some examples of growth industries include food and
drug companies. Value stocks are those trading with low multiples
of earnings, book value or cash flow. Cyclical companies like paper
and trucking firms are examples of value stocks. If you like
bargain hunting, value investing is for you.

Which should you go with? Currently, analysts are more in favor
of value small caps because of their lower valuation. As of the end
of June, the trailing price-to-earnings ratio of the value
companies of the Russell 2000 was 18.9 vs. 35.8 for the
small-company growth sector. The projected 12-month P/Es are 15.1
and 24.2. Should you plow all your small cap money into value
stocks, then? Unless you have a crystal ball, it's still wise
to diversify and invest a bit in both sectors.

When it comes to diversifying your investments and getting the
most from your money, small-company stocks could add diversity and,
over time, help manage your risk. Seems like it's a small
world, after all.

Lorayne Fiorillo is a financial advisor and first vice president
at Prudential Securities Inc. She presents retirement planning and
personal finance workshops worldwide. For more information, write
to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.
All figures are courtesy of Prudential Securities. Past performance
is no guarantee of future returns.